When you open a new line of credit, you enter into a contractual agreement with the lender to whom you will pay back the borrowed money per the terms of the loan or credit card. If you miss payments, the lender will usually try to work with you directly in the early stages of missed payment cycles in hopes of helping you become current on the account.
If you continue to decline paying as agreed, you will enter what is called late stage delinquency status and eventually the lender will write off or charge off your account (typically, when a consumer has become 180+ days past due). Generally speaking, your charged-off account is then “turned over or sold” to a collection agency, which will continue to try and collect on the amounts owed.
[Resource: 11 Ways A Debt Collector May Be Breaking the Law]
Many people assume that if they pay off the amount owed on the collection account, the collection will be removed from the credit report and, therefore, no longer have a negative effect on the credit score. This is a fallacy. The paying off (or paying a portion) of an amount owed on a collection account will not result in that data being removed from the credit report. The account will be updated, nonetheless, to show that it has been paid. The collection account and the original account, along with all previous late payments, will be deleted seven years from the original delinquency date.
Paying off the collection account may not have any positive effect on the credit score. The fact that a collection account is on your credit report (regardless of balance) is, in and of itself, predictive of future risk, as research shows that consumers with collection accounts on their credit report are less likely to pay as agreed in the future than consumers with no credit report blemishes.
This information should not be taken to mean a person should not pay off a collection account if they have the means and they are responsible for the account. It’s worth pointing out that lenders tend to leverage more than just a credit score for lending decisions and may have additional credit criteria that takes this into consideration when they review applications for new credit.
[Related article: Daddy, Make the Bad Man Go Away]